What Is a Zero Cost Refinance?
When mortgage interest rates are low, brokers sometimes advertise zero-cost refinances. These refinances allow a homeowner to get a new mortgage with the same principal balance as is left on the existing mortgage, but with a lower interest rate. In addition, the homeowner does not have to pay any of the usual closing costs or broker fees.
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How it Works
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Mortgage lenders sometimes offer a yield-spread premium, which is a rebate given to customers who initiate mortgages with interest rates slightly higher than the usual advertised rate. In a zero-cost refinance, the borrower chooses an interest rate that is just high enough for the yield-spread premium cover all of the closing costs of the mortgage. As long as this rate is still lower than the interest rate on the homeowner's previous mortgage, the refinance is a good deal.
Benefits
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A zero-cost refinance allows the homeowner to lock in a lower interest rate without having to pay a penny more than he owes on his old mortgage. People who do not have cash to spare can still reap the benefits of a lower interest rate. In addition, homeowners who are considering selling in the near future can still refinance without having to worry about whether they will recoup the closing costs through lower monthly payments over a few years.
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Considerations
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If a homeowner plans to keep the mortgage for a long time, paying for the closing costs upfront would be more financially advantageous than paying the slightly higher interest rate for the duration of the mortgage. The higher interest rate might cause the monthly payment to be $13 more than if the borrower had paid the $1,500 closing costs at the time of the refinance, for example. After 10 years, the homeowner has paid more than $1,500 extra in the monthly payments and continues paying even more over the life of the loan.
Warning
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Loan officers use a few similar terms to describe ways for homeowners to avoid paying closing costs out of pocket. Sometimes, a mortgage that is advertised with "no closing costs" actually involves increasing the amount of the mortgage to include the closing costs as well. For example, if a homeowner owes $150,000 on the previous mortgage and the refinance closing costs come to $1,500, the refinanced mortgage will be for $151,500. In this case, the homeowner pays the closing costs over time, plus interest.
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